Indexation In Mutual Funds

Indexation in mutual funds adjusts the purchase price of an investment to account for inflation from the time of purchase to the time of sale. It helps to reduce the amount of capital gains that are liable for tax, thereby saving investors from heavy tax burdens.

Contents:

• What Is Indexation In Mutual Funds?
• Indexation Benefit In Mutual Fund
• How To Calculate Indexation In Mutual Fund
• Indexation Formula
• Cost Inflation Index
• What Is Indexation In Mutual Funds – Quick Summary
• Indexation In Mutual Funds – FAQs

What Is Indexation In Mutual Funds?

In mutual funds, indexation is like updating the price you first paid for your investment to show how inflation has affected it. It’s like changing the original cost to match today’s money value. This gives a more accurate picture of what your investment is worth now, considering inflation since you bought it.

For instance, consider an investor who purchased units of a debt mutual fund for Rs 100,000 in 2016 and sold them for Rs 150,000 in 2024. The raw capital gain would be Rs 50,000. However, after applying indexation, the purchase price may adjust to Rs 120,000, reducing the taxable gain to Rs 30,000. This adjustment helps the investor mitigate the tax burden while factoring in inflation’s eroding effect on the investment’s purchasing power.

Indexation Benefit In Mutual Fund

The main benefit of indexation is that it allows investors to adjust the purchase price of their investments for inflation. By using the indexed cost of acquisition, the taxable capital gains are reduced, resulting in a lower tax liability.

Additional benefits of indexation are discussed below:

• Inflation Safeguard: Indexation adjusts the original cost of an investment, thereby shielding its value from inflation’s erosion.
• Enhanced Actual Returns: By reflecting the true purchasing power, indexation helps generate greater real returns. It provides an inflation-adjusted view of profit.
• Tax Advantage with Long-term Capital Gains: Indexation benefits are best reaped in long-term investments, as these are taxed lower than short-term gains, boosting post-tax returns significantly.
• Fosters Long-term Investment: The tax relief provided by indexation encourages investors to maintain their investments over an extended period, promoting long-term wealth growth.
• Easy and Handy: The computation of taxable gains for debt mutual funds inherently considers indexation benefits. The process is straightforward since tax authorities readily provide the indexation factor.
• Portfolio Diversification: Debt mutual funds offer an alternative to traditional investment avenues like stocks. Their indexation feature appeals to conservative investors seeking stable returns with minimal tax implications.

Let’s take an example to simplify – An investor bought units in a debt mutual fund for Rs 100,000 in 2016. In 2024, the investor sold these units for Rs. 200,000. Without indexation, the capital gain would be Rs 100,000. However, when indexation is applied, the adjusted cost of acquisition might rise to Rs 130,000, reducing the taxable gain to Rs 70,000. Thus, indexation benefits the investor by decreasing the tax payable.

How To Calculate Indexation In Mutual Fund

Calculating indexation in mutual funds involves a series of steps that adjust the purchase cost of the investment for inflation. 

1. Determine the cost inflation index (CII) for the year of purchase and sale. The CII is published annually by the government of India.
2. Divide the CII of the sale year’s CII by the purchase year.
3. Multiply the result by the original purchase price to obtain the indexed acquisition cost.
4. Subtract the indexed cost from the sale price to calculate the indexed capital gain.

To illustrate, consider an investor who bought mutual fund units for Rs. 100,000 in 2016-17 (CII = 254) and sold them in 2024-25 (CII = 317). The indexed cost of acquisition is (317/254) * Rs. 100,000 = Rs. 124,803. The indexed capital gain (assuming a sale price of Rs. 150,000) is Rs. 150,000 – Rs. 124,803 = Rs. 25,197.

Indexation Formula

The indexation formula is (Index of sale year/Index of purchase year) x Purchase Price = Indexed Cost.

Applying this formula helps determine the indexed cost of acquisition, which is then subtracted from the sale price to calculate the indexed capital gain. Suppose an investor bought mutual fund units for Rs. 200,000 in the financial year 2016-17 (Index = 254) and sold them in 2024-25 (Index = 317). Using the indexation formula, the indexed cost is (317/254) x Rs. 200,000 = Rs. 249,606.

Cost Inflation Index

The Cost Inflation Index (CII) is a measure of inflation used to calculate long-term capital gains for the purpose of tax computation. The Indian government announces the CII for each financial year.

For example, in the financial year 2016-17, the CII was 254, and for 2024-25, it is 317. The difference reflects the effect of inflation over these years, which is considered when calculating the indexed acquisition cost for mutual fund investments.

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What Is Indexation In Mutual Funds – Quick Summary

1. Indexation is a technique used in taxation that adjusts the purchase price of an investment to account for inflation from the time of purchase to the time of sale.
2. It helps to reduce the amount of capital gains that are liable for tax, thereby saving investors from heavy tax burdens.
3. The benefits of indexation mainly come into play when calculating long-term capital gains from debt mutual funds.
4. The calculation of indexation involves the Cost Inflation Index (CII), and the indexation formula calculates the indexed acquisition cost.
5. The indexed cost is then subtracted from the sale price to determine the indexed capital gain, which is subjected to tax.
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Indexation In Mutual Funds – FAQs

1. What is indexation with an example?

Indexation is a process that adjusts the purchase cost of an investment for inflation. For instance, if you purchased a mutual fund unit for Rs. 100,000 in 2016-17 (CII = 254) and sold them in 2024-25 (CII = 317). The indexed cost of acquisition is (317/254) * Rs. 100,000 = Rs. 124,803. The indexed capital gain (assuming a sale price of Rs. 150,000) is Rs. 150,000 – Rs. 124,803 = Rs. 25,197.

2. Is indexation allowed on mutual funds?

Yes, indexation is allowed on mutual funds, specifically debt mutual funds. It is used while calculating long-term capital gains tax on the sale of these funds.

3. How is indexation calculated on mutual funds?

Indexation is calculated using the Cost Inflation Index (CII) of the purchase and sale year. The CII of the sale year is divided by the CII of the purchase year, and the result is multiplied by the purchase price.

4. Can I earn capital gain in a mutual fund without indexation?

Yes, you can accrue capital gains from mutual funds without indexation. However, these gains will be taxed at a standard rate, which may be higher compared to using indexation benefits.

5. How do I claim indexation benefits?

Here are some ways to claim indexation benefits: 

• You must hold your mutual fund investment for more than three years. 
• When you sell the units, indexation is applied to the purchase cost while calculating capital gains tax. 
• Your tax consultant or mutual fund house can guide you through the process.